Professor Cole's Finance Blog

Today, the Wall Street Journal published an article asking if commercial real estate will be the next "mortgage crisis." This article focuses on the exposure of the $700 billion Commercial Mortgage-Backed Securities (CMBS) market rather than the $1.7 trillion in commercial mortgages held by the banking industry. The total value of commercial real estate is estimated to be $6.7 trillion.

The article points out that borrowers face two different types of problems. First, occupancies and rents are down as a result of the recession. Second, and potentially more problematic, borrowers are finding that they are unable to refinance maturing loans, even when their properties are producing sufficient cash flows to service those loans. This is a result of the continuing fallout from the meltdown of the credit markets that began as a result of the Fed's bungled handling of Lehman Brothers and AIG back in September of 2008. More than $150 billion in CMBS is maturing and in need of refinancing during the next three years.

CMBS borrowers also are facing many of the same problems as homeowners whose residential mortgages were securitized. They have difficulty in even identifying who owns their mortgages, and they find that the servicers of these securities are woefully understaffed and unprepared for dealing with the growing volume of delinquencies, which have increased by 600 percent during the past year to more than 3 percent. If the rest of the $6.7 trillion commercial real estate industry is in similar shape, this translates into more than $200 billion in troubled commercial real estate properties.

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Yesterday, the Department of Labor released its latest report on weekly unemployment-insurance claims. For the week ending August 22, the seasonally adjusted claims figure was 570,000. That's right; more than half a million Americans made an initial claim for unemployment insurance.

But, DOL continues, that is good news, because this figure was down an amazing 10,000 from the previous week, and the 4-week moving average fell by 4,750 to only 566,250. I'm sure each and every one of those workers is so relieved that the economic ship of state is taking on water at a slightly slower pace.

Of course, buried in a table is the comparable figure for one year ago: 433,000. So we are losing 140,000 more jobs per week than a year ago, but things are improving.

Yet another green shoot!

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This morning, the FDIC released information on the performance of the banking sector during the second quarter of 2009. In aggregate, the industry lost $3.7 billion dollars primarily as a result of provisions for bad loans. Loan quality continued to deteriorate, with loans past due 90 or more days and still accruing interest or in nonaccrual status as a percentage of total loans reaching 4.35%--the highest level in the 26 years that the FDIC has tracked this measure of loan quality,dating back to 1984. This includes virtually the entire banking crisis era of the mid-1980s through early 1990s, when more than a thousand banks were closed. When loans past due 30-89 days and OREO are included, this ratio jumps to 6.65%. As a percent of total assets, this broader measure of nonperforming assets is 3.8%. The volume of noncurrent loans increased by $41.4 billion or 14.3%, led by noncurrent residential mortgages (up 12.7%), construction and development loans (up 16.6%) and non-farm non-residential loans (up 29.2%). Commercial real estate is the next emerging crisis area for the banking industry but also for the CMBS industry.

The number of "problem banks" (those with CAMELS ratings on 3, 4 or 5) increased from 305 to 416--the highest number in 15 years--in spite of the fact that 39 institutions were merged into other institutions and 24 were closed. However, the assets of "problem banks" rose from $220 billion to only $300 billion. This indicates that the FDIC and other bank regulators cling to the fiction that Citibank, Bank of America and Well Fargo should not be classified as "problems."

Until our commercial banking system returns to health, the U.S. economy will continue to flounder. The much-ballyhooed "stress tests" were nothing more than a PR stunt by the Fed and other bank regulators; in fact, the banking industry remains in dire and deteriorating condition. Look for as many as 100 more banks to fail by the end of 2009.

Next year holds new perils for the banking industry. As the New York Times reported in yesterday's edition, there are approximately 600,000 option-ARM mortgages that will be repricing during the next couple of years, primarily during 2010 and 2011. Option ARMs are nasty little products that allow for negative amortization; that's right, your loan balance increases rather than decreases over time. Most borrowers take advantage of the negative amortization option. When the outstanding balance reaches 115% to 125% of the initial loan balance, these mortgages become fully amortizing, meaning that monthly payments double, triple or worse. The aggregate value of these mortgages is in the range of $750 billion, or approximately the same size as the cohorts of subprime mortgages that precipitated the ongoing financial crisis. The value of MBSs and CDSs tied to these option ARMs is largely unknown. Analysts estimate that as many as four out of five of these option ARMs will go into default. So, just at we run out of subprime mortgages that are not already in default, option ARMs will fill the void, inflicting additional and massive losses on lenders.

Green shoots, anyone?

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The CBO has now followed the OMB in revising its budget deficit estimates for the next decade. CBO's new estimate of $7.14 trillion is almost $2 trillion less than OMB's $9 trillion estimate because of some of the ridiculous assumptions used by CBO. That said, CBO's new estimate is a whopping 60% increase over its previous estimate of $4.4 trillion from March 2009. The OMB revision was up by only about 25% from its previous estimate. These revisions point to four conclusions:

(1) The current Congress it out of control with its spending.

(2) The level of confidence that you should place in these estimates is near zero; the actual numbers are more likely to be triple current estimates, as we saw with the recent "cash-for-clunkers" program.

(3) No matter how much you earn or what your party affiliation, your taxes are going to skyrocket during the coming years.

(4) Inflation is going to become a leading economic concern during the coming years; look for double-digit interest rates by 2011.

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Today, President Obama announced that he was nominating Ben Bernanke for a second term as Chairman of the Federal Reserve's Board of Governors. In my mind, this is like rewarding a firefighter-arsonist for putting out the fires he started. Without the Fed's bungled handing of Bear Stearns, Lehman Brothers, AIG and Washington Mutual, the crisis of confidence would never have escalated into a near-meltdown of the U.S. and world financial system. Bernanke, along with then NY-Fed President and now Treasury Secretary Timothy Geithner, spearheaded these efforts.

As Walter Bagehot set forth in his classic 1870s book Lombard Street, the role of a central banker in a crisis is to lend freely, albeit at a penalty rate, to anyone with good collateral. Bernanke turned Lehman away because it was not a "bank," but, less than 48 hours later, gave up the store to AIG, which also was not a "bank." In so doing, he threw the financial markets into a panic from which they have yet to recover.

For this, President Obama rewards Bernanke with another term during which to rescue his tarnished legacy. Of course, President Obama rewarded former NY-Fed President Timothy ("I forgot to pay my taxes") Geithner for his part in bringing about the financial crisis by appointing him U.S. Treasury Secretary. Nothing seems to succeed like failure when it comes to this administration's financial team!

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Today, I taped an interview (Is the Stimulus Paying Off?) with Tom Hudson of First Business on whether or not the administration's $787 billion Stimulus Package is paying off. The discussion started with reference to the $3 billion "Cash-for-Clunkers" program, which provided rebates of up to $4,500 for buyers of new cars that traded in their "clunkers."

There are at least four lessons we can learn from the "Cash-for-Clunkers" program that are instructive as the administration and Congress push for an overhaul of our health-care system.

(1) The government always under-estimates demand for, and costs of, such subsidies.

The original outlay for clunkers was estimated at $1 billion. The final cost will exceed $3 billion. Expect the cost of the health-care overhaul to be at least three times what is originally estimated.

(2) The government always under-estimates the bureaucracy needed to deal with new programs.

Originally, the government assigned 300 workers to the clunkers program, which turned out to be woefully inadequate (see point (1)). This week, the government announced that it has added 800 workers for a total of 1,100 bureuacrats working on this program, which, by the way, has now expired. Once hired, never fired. Expect the size of the government's health-care bureaucracy to grow like a bad rash, once passed.

(3) We all pay for the costs of these programs, but few of us benefit.

Roughly half a million U.S. residents will receive the "clunker" rebate, but the program will be paid by all U.S. federal taxpayers. Then again, more than half of all U.S. residents pay no federal income tax, so it the the rest of us suckers that are stuck with the costs of these programs. With the proposed health-care overhaul, the CBO estimates that about 12 million uninsured U.S. residents will gain new coverage, but at a cost of more than $1 trillion over ten years, or more than $8 thousand per year for each newly insured resident. If lesson (1) holds true, expect this to triple to $24 thousand per year.

(4) The government never considers unintended consequences of its programs.

At a time when most U.S. consumers are deeply in debt, the government has enticed more than half a million of them to take out car loans in amounts at least four times the subsidy provided, or more than $12 billion in new consumer debt. How many will this push over the edge and into bankruptcy as the economy continues to deteriorate? Only time will tell.

What will be the unintended consequences of the proposed health-care overhaul? It is instructive to remember how we got our current system that relies upon employer-provided benefits. This system came about during World War II when the government imposed wage-and-price controls at time when labor was scarce. To compete for these workers, employers gamed the system by offering "free" health insurance to new workers. Once the war ended, this new system remained in place. Insurance companies then learned to use employers as convenient "risk-pools" for calculating actuarial losses. Now, if you are not in such a "risk-pool," you fall into the high-risk "pool" of individuals without employer provided benefits and will be charged high premiums for an individual policy.

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Today, the Mortgage Bankers Association released its quarterly National Delinquency Survey for the second quarter of 2009, which shows that the delinquency rate for one-to-four residential properties rose to a new seasonally adjusted high of 9.24 percent of all loans outstanding and that the percentage of loans in the foreclosure process rose to a new high of 4.30 percent. In other words, the housing situation continues to deteriorate in spite of the administration's $50 billion foreclosure mitigation plan, which, thus far has been an abysmal failure. Almost one in seven mortgages is now delinquent or in default, and this doesn't include the additional millions of mortgages that are estimated to be "underwater," where the property is worth less than the mortgage.

Also of note in this report is the finding that the seasonally adjusted delinquency rate on FHA loans (insured by the Federal Housing Administration) rose to 14.42 percent. The FHA loan is the "new subprime loan." The FHA requires a down payment of only 3.5%, most closing costs can be included in the loan, and the FHA is "more forgiving" than other lenders when it comes to your credit history. I'm not making this up!

One aspect of this problem that has been neglected is the feedback effect that the housing market has on employment. According to the U.S. SBA, small businesses account for more than half of all employment growth in the U.S. Home equity is the seed capital for most small businesses. As home equity has dwindled during the financial crisis, so has the equity position of most small businesses. When a firm's equity base is declining, it is likely to cut back on employment. Hence, the financial crisis has brought about a decline in small business equity as home equity has declined, which leads firms to lay off workers, who then cannot pay their mortgages, leading to more foreclosures and completing the feedback loop.

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